QUESTION 2

Sprite Limited is a Zimbabwean based manufacturer of heavy duty equipment. The company is currently investigating two projects for expansion. It can only undertake one of them and has asked your advice in deciding which one to proceed with.

Project 1: Production at the existing factory could be expanded. The cost of the new plant for this option would be an initial outlay of ZW$45 million. This would result in an additional ZW$950 000 profit being earned in each of the 10 years that the project would last. The new plant to be fully depreciated over the 10 years, on a straight-line basis, in accordance with the company's accounting policy. The financial team has also determined that the new plant must bear its share of the existing overheads and that amounted to ZW$150 000 per annum. These expenses were also included in the profit calculation. Consultant fees cost R550 000.

Project 2: Production could be increased by purchasing a new manufacturing facility in South Africa. The cost of the facility would be an initial outlay of R250 million. Annual sales for the 10 year period is expected to be R125 million annually, and fixed and variable cost of R50 million and R64.4 million respectively. The fixed cost includes depreciation of R25 million per annum. Consultants fees is expected to be R1.45 million.

Additional information:

The South African inflation is expected to exceed the Zimbabwean inflation by 2% throughout the life of the project.

Sprites cost of capital is currently 12%.

The current spot exchange rate is R7.50/ZW$.

Required: 2.1 Make all the necessary calculations for the two options in order to advise Sprite Limited if it is worth investing in neither, in one or in both of these projects (25 Marks)